How Home Loans Work

By: Luke Ashworth

Most of us understand the advantages of owning a home versus renting one. However, we also know that it would be extremely challenging to arrange for the finances without some help. And so we decide to borrow money from banks and mortgage lenders, in order to fulfil our dream of owning our homes. Here is a guide to help you understand basic concepts of home loans:

Mortgage: A mortgage is basically the pledging of property to a creditor as security for the payment of a debt (Webster). Essentially, when you take the loan, you agree to let the lender hold the title to your house until the debt is completely paid off. You are also empowering the lender to sell your house in case you can't make your mortgage payments.

Paying for your house includes arranging for the down payment, the mortgage payment (which consists of the principal, the interest, taxes, and insurance - referred to as PITI), and closing costs.

Down payment: This is the lump sum you pay upfront - you are required to pay some of the money for the house from your own savings. The greater the amount you can arrange for the down payment, the lesser the amount you have to borrow - this translates to lower monthly instalments. Typically, you need to arrange at least 3 to 5 percent of the purchase price on your own.

Principal: The total amount of money that you are borrowing from the lender is referred to as the principal. Usually the principal is the cost of the house minus the share that you are paying (down payment).

Interest: Why would the lender bother to lend you money? To earn interest, of course. The interest is basically an amount over and above the borrowed amount, that you are paying to the lender in monthly instalments in addition to the principal you are returning. The interest rate is usually decided at the time of finalizing the mortgage arrangements - it can be fixed or variable.

Taxes: You are required to pay property taxes - the amount for this is often set-aside in an escrow account. What this means is that the money is placed in the hands of a third party until it is time to pay or certain conditions are met. A part of your property tax is added to your monthly mortgage payment. The amount is then held in escrow until it is due.

Insurance: Insurance can be of different types - hazard insurance (to protect against losses from fire, storms, theft), flood insurance (if you live in a flood risk zone), and then there is the private mortgage insurance or PMI that you will have to pay (if you have less than 20 percent equity in your home).

Closing Costs: Besides the above mentioned costs, you will have to arrange for closing costs. Closing costs include loan origination fee, discount points, appraisal fee, title search, title insurance, survey, taxes, deed-recording fee and credit report charges. These costs are also known as 'settlement costs'.

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